You may think that it’s easy to know if you are making profitable investments ; if you make money, the investments are successful. If they lose money they are not profitable investments. Right?
While this model of performance is generally true, many investors apply this incorrectly and make huge investment errors as a result. Here are the three top ways many people evaluate “profit” that can get them into trouble:
1. Time Frame
If you determine that the only way your investments are successful is if you make money each and every month, the only investment alternatives available to you are bank CDs. With interest rates for one-year bank deposits coming in about 1% (before taxes and inflation) it will be difficult to reach your financial goals even though your investments are “successful” (according to your primary directive and definition).
This is just an interesting twist on the theme of “winning the battle and losing the war”. Clearly, defining investment success as never losing money (the flip side of always making money) is a non-starter.
So the first question you must ask yourself when you define a profitable investment is, over what time frame? And the problem here is that if your time frame is long, you have to make decisions today about a future you are uncertain about.
Let’s go on.
Let’s say you decide that investing in the bank is for the birds and that you want to grow your money relatively safely for the long run. You decide to invest in a balanced mutual fund.
You want to know if your strategy is successful so you compare your performance to that of the overall market or S&P 500 index. You do a little investigation and learn that your fund earned 10% while the overall market was up 15%. Should you conclude that your mutual fund performance was stinky?
Not really. You invested in a balanced fund which has both equity and fixed income investments in the mix. You invested in that fund because you didn’t want all the risk of having all your money in a growth portfolio of stocks. How can you come back now and compare your performance to an all-equity index? You really can’t if you want to make a fair conclusion.
If your long-term goals are to grow your money safely so you don’t have to worry about your future, you have to evaluate your performance over a very long time. Mark Hulbert is a noted follower of investment strategies. In January of 2012 he noted (in his Market Watch column) that the only way to accurately evaluate a growth strategy is to examine it over at least 15 years. That is not to say that you must hold a fund for that period of time. Mr. Hulbert is saying that you should evaluate your investment approach over that time period.
Forget the track record of the last year or two. What has your approach done over the last 15 years? You might have an approach that selects funds based on short-term performance (like me) or you might be a buy and hold investor. Whichever way you go, it doesn’t matter. Just make sure you evaluate the approach over (at least) 15 years.
Look for proof that your approach has done a good job of weathering a variety of market conditions and the only way to do that is to look at a very long-term track record.
Are you making profitable investments? How do you know?